Download Chapter 9 (6 spp) - N. Meltem Daysal

Learning Objectives
• difference between short run & long run
• introduction to aggregate demand
• aggregate supply in the short run & long
run
• see how model of aggregate supply and
demand can be used to analyze shortrun and long-run effects of “shocks”
Chapter 9
Introduction to Economic
Fluctuations
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Real GDP Growth in the United
States
Time horizons
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Percent change
from 4 quarters
8
earlier
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Average growth
rate = 3.5%
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Why do we need a new approach when the
time horizon changes?
• Long run: Prices are flexible, respond to
changes in supply or demand (Classical
Dichotomy holds; i.e. a change in money
supply only effects prices)
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2
0
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1960
1965
1970
1975
1980
1985
1990
1995
2000
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The Model of
Aggregate Demand and Supply
• Short run: many prices are “sticky” at some
predetermined level (Hence a change in
money supply would be partially adjusted by a
change in real variables)
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Aggregate Demand
• The aggregate demand curve shows the
relationship between the price level and the
quantity of output demanded.
• the paradigm that most mainstream
economists & policymakers use to think
about economic fluctuations and policies to
stabilize the economy
• For this chapter’s intro to the AD/AS model,
we use a simple theory of aggregate demand
based on the Quantity Theory of Money.
• shows how the price level and aggregate
output are determined
• Chapters 10-12 develop the theory of
aggregate demand in more detail!!!!
• shows how the economy’s behavior is
different in the short run and long run
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1. The Quantity Equation as Aggregate Demand
• From Chapter 4, the quantity equation
MV = PY
the postulated money demand function and
money market equilibrium implies V id constant
where V = 1/k :
(M/P )d = k Y=(M/P)
.
2. The downward-sloping AD curve
An increase in the
P
price level causes a
fall in real money
balances (M/P ),
causing a decrease
in the demand for
goods & services.
(This explanation is
different than the
one given in Ch 9)
• For fixed values of M and V, these equations
imply an inverse relationship between P and Y:
AD
Y
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Aggregate Supply
e.g. Shifting the AD curve
(Monetary Policy)
P
An increase in
the money
supply shifts
the AD curve
to the right.
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• AS describes the relationship between the
quantity supplied and price level.
• Because the firms that supply goods and
services have flexible prices in the LR and
sticky prices in the SR the AS depends on
the time horizon.
AD2
AD1
Y
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The long-run aggregate supply
curve
1. Long Run
In the long run, output is determined by
factor supplies and technology
P
LRAS
Y = F (K , L )
Y
The LRAS curve
is vertical at the
full-employment
level of output.
is the full-employment or natural level of
output, the level of output at which the
economy’s resources are fully employed.
Full-employment output does not depend on the
price level, so the long run aggregate
supply (LRAS) curve is vertical:
Y
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Y
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2
e.g. Long-run effects of an
increase in M
P
LRAS
An increase
in M shifts
the AD
curve to the
right.
P2
In the long
run, this
increases the
price level…
2. Short Run
P1
AD2
AD1
…but leaves
output the
same. (CD)
Y
Y
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The short run aggregate supply
curve
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e.g. Short-run effects of an
increase in M
P
The SRAS curve
is horizontal:
The price level is
fixed at a
predetermined
level, and firms
sell as much as
buyers demand.
• In the real world, many prices are sticky
in the short run.
• For now (and throughout Chapters 9-12),
we assume that all prices are stuck at a
predetermined level in the short run…
• …and that firms are willing to sell as
much as their customers are willing to
buy at that price level.
• Therefore, the short-run aggregate
supply (SRAS) curve is horizontal:
In the short run
when prices
are sticky,…
SRAS
P
P
…an increase
in aggregate
demand…
SRAS
AD2
AD1
P
Y
…causes
output to rise.
Y1
Y2
Y
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3. From the short run to the long run
The SR & LR effects of ∆M > 0
Over time, prices gradually become “unstuck.”
When they do, will they rise or fall?
In the short-run
equilibrium, if
A = initial
equilibrium
then over time,
the price level will
Y >Y
rise
Y <Y
fall
Y =Y
remain constant
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B = new shortrun eq’m
after Fed
increases M
This adjustment of prices is what moves
the economy to its longlong-run equilibrium.
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C = long-run
equilibrium
P
LRAS
C
P2
P
B
A
Y
Y2
SRAS
AD2
AD1
Y
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The effects of a negative demand
shock
Stabilization Policy
• shocks: exogenous changes in aggregate
supply or demand
• Shocks temporarily push the economy away
from full-employment.
• An example of a demand shock:
exogenous decrease in velocity
• If the money supply is held constant, then a
decrease in V means people will be using
their money in fewer transactions, causing a
decrease in demand for goods and services:
The shock shifts
AD left, causing
output and
employment to fall
in the short run
P
P
Over time, prices
fall and the
economy moves
down its demand
curve toward fullemployment.
LRAS
A
B
SRAS
C
P2
AD1
AD2
Y2
Y
Y
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CASE STUDY:
Supply shocks
The 1970s oil shocks
A supply shock alters production costs,
affects the prices that firms charge.
(also called price shocks)
Examples of adverse supply shocks:
Bad weather reduces crop yields, pushing up
• Early 1970s: OPEC coordinates a
reduction in the supply of oil.
food prices.
Workers unionize, negotiate wage increases.
New environmental regulations require firms to
reduce emissions. Firms charge higher prices to
help cover the costs of compliance.
(Favorable supply shocks lower costs and
prices.)
• Oil prices rose
11% in 1973
68% in 1974
16% in 1975
• Such sharp oil price increases are supply
shocks because they significantly impact
production costs and prices.
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CASE STUDY:
P
P2
P1
In absence of
further price shocks,
prices will fall over
time and economy
moves back toward
full employment.
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Stabilization policy
The 1970s oil shocks
The oil price shock
shifts SRAS up,
causing output and
employment to fall.
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LRAS
• Def: policy actions aimed at reducing the
severity of short-run economic fluctuations.
B
• Example: Using monetary policy to combat
the effects of adverse supply shocks:
SRAS2
A
SRAS1
AD
Y2
Y
Y
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Stabilizing output with
monetary policy
The adverse
supply shock
moves the
economy to
point B.
P
P2
Stabilizing output with
monetary policy
LRAS
B
But the Fed
accommodates
the shock by
raising agg.
demand.
SRAS2
A
P1
SRAS1
Y
P2
P1
results:
P is permanently
higher, but Y
remains at its fullemployment level.
AD1
Y2
P
Y
LRAS
B
SRAS2
C
A
AD2
AD1
Y2
Y
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Chapter summary
Y
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Chapter summary
1. Long run: prices are flexible, output and
3. The aggregate demand curve slopes
employment are always at their natural
rates, and the classical theory applies.
Short run: prices are sticky, shocks can
push output and employment away from
their natural rates.
downward.
4. The long-run aggregate supply curve is
vertical, because output depends on
technology and factor supplies, but not
prices.
2. Aggregate demand and supply:
5. The short-run aggregate supply curve is
a framework to analyze economic
fluctuations
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horizontal, because prices are sticky at
predetermined levels.
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Chapter summary
6. Shocks to aggregate demand and supply
cause fluctuations in GDP and employment
in the short run.
7. Poor monetary policy can be a source of shocks
to the economy. Also, the Fed can attempt to
stabilize the economy with monetary policy.
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